Is Personal Loan Interest Tax Deductible?
So many loans have tax-deductible interest, but is personal loan interest one of them? Find out here.
Contributing Writer at Tally
April 1, 2022
This information is provided for informational purposes only, and is not intended to be construed as tax, legal, or accounting advice. You should consult your own tax, legal and accounting advisors before making financial decisions.
At tax time, you can take a wide range of tax deductions that reduce your taxable income and lower the income taxes you owe. These include student loan debt, some business loans, mortgages and more. You may wonder, "Is personal loan interest tax deductible?"
The answer is: sometimes.
Below, we'll cover when personal loan interest is tax deductible and if it makes sense to use a personal loan in these situations. We’ll also provide you with a couple of personal loan alternatives.
Can I deduct personal loan interest from my taxes?
The Internal Revenue Service (IRS) allows you to deduct certain types of interest, but it expressly forbids deducting "credit card and installment interest incurred for personal expenses." This would include personal loans for personal expenses, too — meaning most personal loans will not be tax deductible.
However, the reference to "personal expenses" leaves some room to maneuver within the law.
When is personal loan interest tax deductible?
There are very specific situations when personal loan interest is tax deductible. Let's review these instances.
When you open a business, you may need a small business loan to cover the costs of running it until it's self-sustainable. In some cases, this could be a personal loan, but a portion or all of this personal loan could be tax deductible if you use it the right way.
If you use a portion or all of the personal loan for business purposes, such as buying supplies, furniture, business property and other business expenses, you can deduct the interest associated with those expenses from your business profit, reducing the business' income tax.
Keep in mind, if you use a portion of the loan for a personal expense, you must keep track of the interest payments separately, as that portion is not tax-deductible. This tax deduction also works for self-employed folks, such as freelancers and contractors.
Qualified educational expenses
Taking out federal student loans to cover higher education costs can be a wise financial move. They offer various benefits, like forbearance, deferment, income-driven repayment plans, loan forgiveness and more, whereas other loans do not.
Private student loans are usually the second-best option, as they also offer favorable interest rates and other benefits. However, if you have qualified education expenses that exceed your student loan amount, you can take out a personal loan.
And, when you use a personal loan for qualified educational expenses, you can take an interest deduction on your taxable income when filing your tax return, just like with student loan interest.
Qualified educational expenses include:
Other required attendance-based fees (not including room and board)
Keep in mind, there are other requirements that must be met in order to deduct your interest, including that the personal loan be considered a “qualified student loan.” This means it needs to have been taken out to cover educational expenses only.
If you used a portion or all of the loan to buy a taxable investment, such as a stock or bond, the interest you pay on that amount could be tax deductible.
However, the tax deduction can only offset the investment interest, reducing your tax liability on just the investment. You cannot deduct this interest from your overall gross income, so it's generally not worthwhile to do this.
Investments with tax benefits, like a 401(k) or IRA, aren't eligible for interest deductions.
When is it a good idea to take out a tax-deductible personal loan?
If you're considering a personal loan for any of the above purposes, take a look at your overall tax situation to make sure it’s the right move for you. You can also speak with a tax professional or accountant who can help weigh in.
Here are a few times when a personal loan may be an appropriate option.
You've maximized all other loan options
When borrowing money for a business or higher education, you have loan options designed specifically for those purposes. However, if you've taken out the maximum loan amounts you can but still need cash, a personal loan may be the only option.
What you want to avoid is taking out a personal loan in lieu of these specialized loans. This is especially true in the case of federal student loans, which offer valuable protections, including forbearance, deferments and income-driven repayment plans.
The personal loan costs are lower
When reviewing a loan offer, evaluating it goes beyond just interest rate and term. It’s wise to consider the overall cost of the loan, including fees. If you find a personal loan with a total loan cost that's lower than the total loan cost of one of the specialized loans, this could be a great option.
When looking at the total loan cost, make sure it includes origination fees and all other administrative fees. This will give you an accurate idea as to whether or not the personal loan is actually a better option. You can find these fees and the total cost of the loan within the loan disclosures you receive to sign.
You don't qualify for any other options
Sometimes, you simply won't qualify for the other loan options.
Whether it's an income issue, a poor credit score or something else, you may only qualify for a personal loan. Before resorting to a personal loan, check your credit card limit and interest rate to compare it to the personal loan terms.
While going into credit card debt isn’t ideal for your personal finances, if the interest rate is lower than the personal loan, it may be the better option.
Alternatives to a personal loan
Before resorting to a personal loan, there are other loan options to consider. Let's explore these types of loans and what they offer.
Debt consolidation loan
If you're considering a personal loan to consolidate credit card debt, you may want to look into a debt consolidation loan. Technically, debt consolidation loans are still personal loans, but their intent is to pay off debt and get your finances back on track.
Because the lender specializes in debt consolidation, they may look past the large amount of debt you plan to pay off with the loan, which can increase your chances of getting a better interest rate. This is especially true if you opt to have the lender pay off your debts directly instead of depositing the funds into your bank account.
Home equity loan
If you own a home with equity in it — equity is the value of the home minus any loan balances attached to it — you may be able to get a home equity loan instead of a personal loan. Because your home equity loan has an asset securing it — your home — the interest rate may be lower than a personal loan.
The downside is, if you default on the loan, the lender can foreclose on your home. Also, if you sell your home, you must repay the home equity loan from the sale proceeds.
Plus, since home equity loan interest is treated as mortgage interest, any portion used to buy, build or improve your home is tax-deductible.
Save on taxes with personal loan interest deductions
In some instances, personal loan interest is tax deductible, but only in very select cases like when the loan is used to pay for business expenses, qualified educational expenses or taxable investments.
In the case of business and qualified educational expenses, there are already specialized loans available, so it’s smart to only use a personal loan if the specialized loan is not an option for you.
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